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loss aversion

Loss Aversion: Bad Behaviour

By Michael Callahan | April 1, 2019

Question. My investments are currently at one of the banks. I have been reviewing my portfolio and how it has performed over the last few years, and I am unhappy with the performance. I have done my homework and my due diligence, and I have decided that I am ready to transfer my investments over to ModernAdvisor and become a client.

However, there is one position in my portfolio that I am reluctant to sell. It is a stock that I bought at $10 per share a few years ago, and it is now at $2. I am concerned that if I sell it, it will go up immediately. So, I am thinking of simply holding on to it until it goes back to $10, then I will sell. Do you think this is a good idea?

Answer. This is not a good idea. It’s a very common mistake but it’s a very bad idea. Why is it so natural to think this way?

In the current situation, you bought a stock at $10 per share, and it’s now at $2. But you haven’t sold it yet, so the loss can be thought of as what is known as a “paper loss”. It is not a “real loss” yet, because in theory, it could go back to $10, in which case you have not actually lost anything – How nice would that be?!

On the other hand, if you sell an investment after it has declined, you must accept the fact that you now have realized a loss. And it is no longer a paper loss – it is real. Furthermore, if you sell at a loss, you must also accept that you’ve made a decision that didn’t work out as planned. Accepting the fact that you have made a poor investment decision is very difficult for most investors. In reality it happens to all investors, including the very best.

For these reasons, it’s only natural that you are reluctant to sell. At the core of this thought process is what is known as “loss aversion”. Let’s take a closer look at what “loss aversion” really is.

Loss Aversion

In cognitive psychology and behavioural finance, the concept of loss aversion refers to our tendency to prefer avoiding a loss to acquiring an equivalent gain. In simple terms, most people would prefer to avoid losing $20, compared to finding $20.

In fact, for most people, the happiness which is experienced by gaining something is far less powerful than the unhappiness felt by losing the same thing. This phenomenon is explained in Prospect Theory, as developed by Israeli psychologists Daniel Kahneman and Amos Tversky.

In reality, Kahneman and Tversky found that we feel the pain of a loss around 2.5 times more than we enjoy an equivalent gain. For a simple demonstration of this effect, assume you are offered a coin toss, where, “if you win you get $100, but if you lose, you have to give away $100.” Would you do it? Most people would not. For most people to accept the coin toss, it would have to be something like, “if you lose you have to give away $100, but if you win you get $250.” Now would you do it? Most people would now accept the coin toss on these terms.

In other words, the potential pain of losing $100 is not offset by the potential happiness of gaining $100. You would need a gain of about $250 for it to “feel” like it is worth accepting the coin toss.

Framing

Consider the following classic experiment by Kahneman and Tversky, then ask yourself how you would choose in each of the following scenarios:

Scenario #1:

In addition to whatever else you currently own, I give you $1,000. Now you have to make a choice between A and B as follows:

  • A: Flip a coin – if you guess right, you will get an additional $1,000; if you guess wrong, you will get no additional money.
  • B: I give you an additional $500.

Which choice would you prefer, A or B? If you are like most people, you would prefer B – the guaranteed additional $500.

Scenario #2:

In addition to whatever else you currently own, I give you $2,000. Now you have to make a choice between A and B as follows:

  • A: Flip a coin – if you guess right, nothing happens; if you guess wrong, you have to give me back $1,000.
  • B: Give me back $500.

Which choice would you prefer, A or B? If you’re like most people, you would prefer A – the coin toss, where you have a chance to keep the full $2,000 and not give up anything.

Note, however, that in scenarios 1 and 2, you are presented with identical choices: in both cases, choice “A” is 50/50 odds between $1,000 and $2,000, and in both cases, choice “B” is a guaranteed $1,500. Mathematically, both scenarios are exactly the same.

This peculiar outcome illustrates the concept of “framing”. Although presented with the exact same choices, when the scenario was framed as a gain, most people chose the guaranteed outcome of $1,500. Yet, when the scenario was framed as a loss, most people chose the riskier option of the coin toss.

Why it Matters

As demonstrated, the fear of losing something makes us focus on avoiding such losses much more than we focus on achieving gains. More importantly, we often take increasingly risky strategies to avoid such losses.

One such risky strategy, and one that we see quite often in practice, is exactly what was described in the original question, “Should I just hold on to it until it goes back to $10, and then sell?”

More generally, the risky strategy here is refusing to sell a stock, even when a rational analysis suggests that it should be sold.

Back to the original question. For context, we include the fact that the client who sent us the question holds 1,000 shares of the stock in question. Therefore, the original investment of $10,000 is now worth $2,000.

Now consider this: Assume your stock was just sold. You now have $2,000 cash and you no longer own the stock. Of course, the shares are still trading at $2. Would you turn around and use your $2,000 to buy 1,000 shares?

If the answer is “no,” then ask yourself, why not? Likely it is because you have just admitted to yourself that it is not a worthwhile investment. Yet, you are holding on to it, and refusing to sell.

Remember, you don’t have to make money in the same place you lost it. It’s ok to dump a losing investment and re-allocate that money elsewhere.

Loss Aversion: Bottom Line

As we have observed, the issue here is an emotional decision, based on the attempt to avoid the pain associated with accepting a loss.

Indeed, there are many psychological factors which play into our investment decisions. While we cannot prevent ourselves from feeling one way or another, we can prevent those feelings from derailing our investment decision-making process. This is a huge distinction.

Better yet, by investing with ModernAdvisor, you will entirely prevent the situation described above, and remove the risk of letting your emotions dictate your investment decisions.

Interested in learning more? Contact us today to find out about the exciting solutions we have to offer.


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Michael Callahan